How do you Calculate ROI?

It can sometimes be relatively easy to determine the ROI of some investments, but seemingly impossible to do so with others. Unfortunately, in our zeal to achieve, we often make it more difficult to isolate the effects of a particular aspect. So what’s needed, in order to properly measure the ROI of an investment?

Identifying costs

Even slight differences in cost can give a very inaccurate picture of the return on an investment. For small investments, the damage may not be significant, for when considering large investments, particularly of an ongoing nature, it’s not hard to imagine potential differences of tens of thousands of dollars or more.

This makes it imperative to ensure that all costs are considered and that they’re accurate. It’s very easy to miss costs that we don’t see as directly related. For example:

Tom is tasked with running the mailroom, making bank runs and driving the company bus each morning and evening, ferrying the company’s daily visitors to and from the airport. Since he’s very savvy about social media, you decide he may be the ideal person to take over that task.

The problem is, Tom spends two hours each day driving the bus, another hour and a half going to the bank and needs four hours per day to handle all the mailroom tasks. The social media monitoring and posting activity is projected to require two to three hours per day. Tom can’t do it all.

You can hire a driver for $10/hr, a mailroom clerk for $8/hr or a social media person for $20/hr. The business decision should be fairly straightforward, with the following options:

  • a driver can relieve Tom of the bus and bank runs, for a daily cost of about $35, freeing 3-1/2 hrs for Tom to handle the social media;
  • a new mailroom clerk can relieve Tom of that responsibility for about $32/day , which will leave Tom with enough time to handle the driving and social media activity;
  • you can hire a social media contractor for about $40-$60/day, leaving Tom’s schedule unchanged.

Now all you have to do is decide which is most economical, right? It might seem that the new mailroom clerk is the least expensive solution, and that may be true. But you need to look at all the additional costs, because they’ll all affect both the business decision and your ROI.

For instance, in your jurisdiction, will the 32 hour work week require you to provide benefits to the new mailroom clerk? If so, you’ll need to consider the additional burden of his health insurance, Workman’s Compensation, Social Security, unemployment insurance, vacation time, etc. as part of the cost of using Tom for social media. If it would make the new clerk a permanent part-time employee, you may be better off hiring a new driver, instead, who would probably not be classified as a permanent employee, with only a 17-1/2 hour work week. An outside social media contractor certainly wouldn’t have that additional burden, but the raw cost is higher.

In reality, the net cost of the driver will probably be the lowest option. Regardless, you need to figure all the additional costs of that change into your costs for your ROI calculation.

Benchmarking and Gains

In order to measure improvement, you’ll have to identify the starting point, and how you do that will depend upon what you’re measuring. The most important part of this aspect of your analysis will be to ensure that your gains metrics are exactly the same as your benchmarking metrics.

Benchmarking will tell you where your performance is before the changes, so you can gauge your investment’s success. Whether your goal is to increase sales or production, improve shipping times or reduce scrap or returns, as long as you know where your numbers were beforehand, where they are afterward and use exactly the same metrics for both, you’ll be able to analyze your ROI.

Calculating ROI

Return on investment is a very simple formula – it’s simply the net benefit of the investment (the total benefit, less total cost), divided by its cost, expressed as a percentage. So a $150 increase in sales from a $100 investment would represent an ROI of 50%.

ROI-1 or in this case, ROI-2

Where many people err is in calculating their total cost. And when you look at the formula, it’s easy to see how a relatively minor omission in cost can have a great effect on your ROI calculation. Let’s say we forgot to include another $20 in cost. Recalculating will give us:

ROI-3

That’s a substantial difference – in this example, a $20 difference in cost cut the ROI by 50%, and a difference of only $5 would still reduce the ROI from 50% to 43%.

The Bottom Line

When you’re looking at before and after snapshots, the above is sufficient to tell you what your ROI really was. But be aware that ROI projections are based upon numbers that can change, even if only slightly. And as you saw above, slight changes can create huge differences in the outcome.

So be cautious when basing any investment decision upon projections. I always suggest fudging your numbers on the side of caution… assume your costs will be at least 10-20% higher and your gains 20-30% lower than you expect. If the ROI still looks worthwhile in that light, you’re on much safer ground.

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Comments

  1. Rocco Msing says:

    Calculation of ROI was not so easy for me. Hence, you have narrated it simplest way. Just brilliant..

  2. Thanks for the detailed article about the calculation of ROI!

  3. Nice, informative article.

  4. Joan J. Carrigan says:

    Most important thing about ROI is not how to calculate it. It is to compare it with others in branch. Then real power of ROI comes. Thanks, great article.

  5. I don’t agree, Joan. First, you can’t compare what hasn’t been accurately calculated. But more importantly, the calculation of ROI will be unique to each site, each task. Even calculating the same task on two or more sites will render different results.
    At the end of the day, what matters more to you – your return on investment or how your spending and results compare to your competitor’s? I’d say the comparison is relatively useless in almost all instances.
    Thanks for commenting.

  6. Sanjeet Veen says:

    This is a good article on calculating ROI. As you rightly mentioned in the beginning of the article calculating the ROI on some investments is difficult. One such investment is what you do on search engine optimization and online branding.

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